Highly specialized markets have evolved through the years to permit the enhanced trading of capital assets, such as stocks and bonds. The fundamental function of these markets is to bring buyers together with sellers so that the subject securities can be exchanged in an efficient and fair manner. To insure fairness and efficiency, the market must provide participants the ability to discover prices that trigger trading. For example, all markets have some mechanism to deliver price information to participants so that trading decisions can be made. Once price discovery exists, the markets must then permit meaningful trading volume to flow evenly and without artificial price disruptions that would otherwise impede fairly priced trading.
In modern security trading, equity securities are traded in two distinct forums. The first and perhaps best known forum is an “exchange”, such as the New York Stock Exchange (NYSE). Major exchanges have a number of unique characteristics and rely on a group of large financial organizations that are well capitalized to act as Specialists on select securities. The second forum for trading is known as over-the-counter or OTC and is exemplified by the National Association of Security Dealers (NASDAQ).
The effectiveness of a trading exchange relies to a great extent on the operation of the Specialist. As stated above, Specialists are responsible for controlling trading of select securities that are assigned to the Specialist. They perform two core functions. First, the Specialist must maintain price continuity. This continuity is characterized by the degree of price change that takes place from one transaction to the next. It is critical and a fundamental objective of the Specialist to minimize price changes between transactions. Second, the Specialist seeks to enhance market depth—that is, the volume of trades at select price changes between transactions.
Specialists operate on the exchange by establishing a price quote for a select security, expressed in terms of a current best bid and offer for specified volume as entered by market participants. The best current bid and offer create a price spread, i.e., the difference between the bid and offer price. Traders then buy and sell based on the quote given and shares are transacted through the Specialist.
In addition to this passive role, the Specialist often participates in a security transaction as a trader in its own name. This is a critical role for the Specialist; as these trades are the vehicle used by the Specialist to maintain price continuity and market depth—and to avoid volatility.
The advent of computer systems has dramatically altered and greatly enhanced the operation of the securities exchanges. Today, virtually all exchanges sophisticated data processing and networking technologies to improve operating efficiency. In most cases, these systems are used as a means of communication between market participants, as exemplified by the New York Stock Exchange's Designated Order Turnaround (DOT) system. Other advanced systems include order matching or crossing programs, such as the NASDAQ Small Order Execution Services (SOES) system, the Chicago Mercantile Exchange's GLOBEX system, and the Mercantile Exchange and ITG's POSIT 4.0 system.
Several patents discuss system for trading. Lupien, et al., U.S. Pat. No. 5,845,266, for a CROSSING NETWORK UTILIZING SATISFACTION DENSITY PROFILE WITH PRICE DISCOVERY FEATURES, issued Dec. 1, 1998, discloses a crossing network that matches buy and sell orders based upon a satisfaction and quantity profile and includes a number of trader terminals that can be used for entering orders. The orders are entered in the form of a satisfaction density profile that represents a degree of satisfaction to trade a particular instrument at various (price, quantity) combinations. Typically, each order is either a buy order or a sell order. The trader terminals are coupled to a matching controller computer. The matching controller computer can receive as input the satisfaction density profiles entered at each one of the trading terminals. The matching controller computer matches orders (as represented by each trader's satisfaction density profile) so that each trader is assured that the overall outcome of the process (in terms of average price and size of fill) has maximized the mutual satisfaction of all traders. Typically, the matching process is anonymous. The matching process can be continuous or a batch process, or a hybrid of the two. Unmatched satisfaction density profiles can be used to provide spread and pricing information. Factors other than price and quantity also may be used to determine the degree of satisfaction. Optionally, priority may be given to certain profiles in the matching process to accommodate stock exchange rules, for example, requiring that priority be given to orders exhibiting the best price, regardless of size or any other consideration.
Lupien, et al., U.S. Pat. No. 5,101,353, for an AUTOMATED SYSTEM FOR PROVIDING LIQUIDITY TO SECURITIES MARKETS, issued Mar. 31, 1992, discloses an automated system for managing one or more large investor portfolios containing both cash and numerous, diversified securities in a real time environment provides added liquidity to the securities markets while maintaining predetermined portfolio objectives for each portfolio. The disclosed system uses data processing equipment to place buy and sell orders on securities markets and with automated brokers to execute trade directly between users of the system and external markets. Holders of such large, diversified portfolios have usually been long-term investors. The system allows active market participation by such investors whereby they provide added liquidity and depth to the securities markets while overcoming problems caused by trader identification and the inability to enter, change or execute orders in a real time environment. The system monitors and analyzes a variety of factors which effect trading decisions in a vast number of securities. Such factors include other security trades, price and size quotations and financial ratios for particular securities. This information is further analyzed in relationship to each investor portfolio using the system to determine what transactions might benefit the portfolio by seeking to provide an incremental return while accommodating the basic portfolio objectives. These objectives may be changed at the election of the investor at any time. Orders representing such transactions are entered by the system and executed in real time either internally between system users or externally with computerized brokers and/or stock exchanges and markets.
Braddock, et al. U.S. Pat. No. 4,412,287, for an AUTOMATED STOCK EXCHANGE, issued Oct. 25, 1993, discloses an automated stock exchange in which a computer matches buy and sell orders for a plurality of stocks. An open board simultaneous trading environment is simulated through two stages. The first stage is an order accumulation period which is continuously in operation except for one stock in the second stage. The second stage is an extremely rapid sequential call through. All orders for a given stock are available to customers during the first stage. During the second stage market orders are matched with market orders, then market orders are traded against limit orders as the trading price changes within controlled ranges. The system will also process stop orders, and other specialized transactions.
See also U.S. Pat. No. 5,950,176.
There is a rich literature on various theoretical models of market-making and the behavior of market-makers. The contributions of these models are limited to theoretical understandings of the economics of the market-making process under simplified assumptions.
Hakansson, et al., “On the Feasibility of Automated Market Making by a Programmed Specialist,” Journal of Finance, 40(1):1-20 (1985) describes an automated specialist that balances excess demand due to discontinuous aggregate demand functions. Kalman, et al., “A Simulation Model of Stock Exchange Trading,” Simulation, 4:181-191 (1991) proposes a model of an automated specialist that stabilizes prices.
At their best, the prior systems provide passive order handling. What is needed is a system that handles services currently handled by humans, such as price discovery, supply of liquidity, and price stabilization.